Application of the Equitable Adjustment Doctrine to Sections ...

Florida Law Review Florida Law Review

Volume 38 Issue 5 Article 5

December 1986

Application of the Equitable Adjustment Doctrine to Sections Application of the Equitable Adjustment Doctrine to Sections

643(e)(3) Election 643(e)(3) Election

David P. Webb

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Recommended Citation Recommended Citation David P. Webb, Application of the Equitable Adjustment Doctrine to Sections 643(e)(3) Election, 38 Fla. L. Rev. 811 (1986). Available at: https://scholarship.law.ufl.edu/flr/vol38/iss5/5

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APPLICATION OF THE EQUITABLE ADJUSTMENTDOCTRINE TO THE SECTION 643(e)(3) ELECTION

DAVID P. WEBB*

I. INTRODUCTION ............................................. 811

II. THE EQUITABLE ADJUSTMENT DOCTRINE ...................... 813A. The W arms Adjustment ................................. 814B. The Rice Adjustment ................................... 816C. Trapping Distributions ................................... 817D. Disproportionate Distributions .............................. 819E. Depreciation Deductions Inuring to the Benefit of the Income Bene-

ficiaty While Increasing the Principal Benewciayy's Tax Burden .. 820F. Sale of Trust or Estate Assets ............................. 821

III. SECTION 643(e) ........................................... 821A. The General Rule ...................................... 821B. The Elective Rule ...................................... 822C. In Kind Property Distributions Where Section 643(e) is Not

Applicable ............................................. 8221. Distribution Within Section 663(a) .................. 8232. Distributions in Satisfaction of Pecuniary Bequests, More

than Three Installments, and Under Sections 651(a)(1)and 661(a)(1) ..................................... 823

3. Property Representing the Right to Receive Income inRespect of Decedent and the Grantor Trust Rules .... 824

IV. APPLICATION OF THE EQUITABLE ADJUSTMENT DOCTRINE TO A

SECTION 643(e)(3) Election ................................ 824A. In Kind Property Distributions From Trusts ................. 825B. Effect of Ordinary Income Recognition Provisions .............. 829

V. TAX EFFECT OF THE EQUITABLE ADJUSTMENT ...................... 830

VI. CONCLUSION .............................................. 830

I. INTRODUCTION"

Prior to enactment of the Deficit Reduction Act of 1984, the Internal Rev-enue Code (the Code) provided that distributions of property in kind to ben-

Associate, Magruder, Montgomery, Brocato & Hosemann, Jackson, Mississippi. B.A.,1982, University of Mississippi; J.D., 1985, University of Mississippi; LL.M., 1986, University ofFlorida. This paper was prepared as part of the requirements of the University of Florida GraduateTax Program.

* * Unless otherwise provided, all code references herein are to the Internal Revenue Codeof 1954, as amended. [Ed. note. On October 22, 1986, Congress enacted the Tax Reform Act of

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Webb: Application of the Equitable Adjustment Doctrine to Sections 643(

Published by UF Law Scholarship Repository, 1986

UNIVERSITY OF FLORIDA LAW REVIEW

eficiaries of a trust or estate were deemed to carry out distributable net income(DNI) to the extent of the property's fair market value at the time of distri-bution.' In such transactions, the trust or estate realized no gain or loss onthe distribution unless the distribution was in satisfaction of a right to receivea specific dollar amount or specific property other than that distributed. 2

The general effect of an in kind distribution of appreciated or depreciatedproperty was a deduction to the estate or trust equal to the property's fairmarket value (provided there was sufficient DNI) and gross income of likeamount to the beneficiary. In addition, the beneficiary received a fair marketvalue basis in the property while the unrealized gain or loss in the distributedproperty went unrecognized to the trust or estate.3 This treatment was incon-sistent with the consequences resulting from a sale of the property by the trustor estate and subsequent distribution of the proceeds to the beneficiary. If incomefrom such a sale were allocated to corpus, the entity would pay tax on thegain. The transaction would otherwise have the same economic results as thefirst mentioned distribution. Thus, two transactions that were in substance thesame had different consequences as a result of application of Treasury Regu-lation section 1.661(a)-2(f)(1)-(3).

The Deficit Reduction Act of 1984 significantly changed the treatment oflike-kind distributions from estates or trusts.4 New section 643(e) provides thegeneral rule that distributions of property from a trust or estate are treated ascarrying out DNI only to the extent of the lesser of the property's basis, adjustedfor gain or loss recognized by the trust or estate on the distribution, or fairmarket value at the time of distribution.5 However, section 643(e)(3) allows thefiduciary to elect to recognize gain or loss on the distribution as if there hadbeen a sale to the beneficiary at fair market value.' Thus, under the generalrule a trust or estate may no longer distribute appreciated or depreciated prop-erty to a beneficiary at a fair market basis and recognize no gain or loss onthe transaction. Unless an election to recognize gain or loss is made, the ben-eficiary takes a basis equal to the trust or estate's basis in the property.

The fiduciary's election, therefore, can have negative or positive conse-quences to beneficiaries, depending on their relative interests in the corpus orincome and applicable fiduciary accounting rules. Under certain fiduciary ac-counting rules, an election under section 643(e) may result in one beneficiary'sreceiving tax benefits while another bears the economic burden. Arguably,such a result justifies some equitable adjustment through the application of the

1986, Pub. L. No. 99-514, 1986 U.S. CODE CONG. & ADMIN. NEws (100 Stat.) 12. Provision wasmade to rename the Internal Revenue Code of 1954 as the Internal Revenue Code of 1986. Id.5 2 (hereinafter referred to as Int. Rev. Code of 1986)].

1. Treas. Reg. § 1.661(a)-2(0(2) (West 1986).2. Id. S 1.661(a)-2()(1).3. Id. S 1.661(a)-2()(3).4. Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 81, 1984 U.S. CODE CoNG. &

ADMIN. NEws (98 Stat.) 597.5. I.R.C. § 643(e)(2) (West 1986).6. Id. § 643(e)(3)(A)(ii).

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Florida Law Review, Vol. 38, Iss. 5 [1986], Art. 5


EQUITABLE ADJUSTMENT DOCTRINE

"equitable adjustment doctrine." 7 Courts have applied the doctrine in similarsituations. 8 This paper presents an overview of the purposes and present ap-plication of both the equitable adjustment doctrine and section 643(e).9 Thepaper then discusses the possibility of such an adjustment and its consequencesunder section 643(e).

II. THE EQUITABLE ADJUSTMENT DOCTRINE

Courts have applied the equitable adjustment doctrine when a fiduciary'selections or decisions financially benefitted some beneficiaries to the detrimentof others. Inequitable consequences can arise because the beneficiaries may havediffering property interests under local law. An equitable adjustment is a methodto compensate for disproportionate sharing of tax burdens through a reallocationof assets from one beneficiary's account to that of another. Considering actualtax consequences, a reallocation or adjustment achieves the goal of impartialtreatment of beneficiaries as required under local law.

Much debate and controversy has arisen concerning the applicability of theequitable adjustment doctrine and adjustments that should be made when itdoes apply. 10 The tax consequences of such adjustments are also at issue." Thebasis of equitable adjustments lies in at least two aspects of the fiduciary duty:(1) the duty of impartiality, and (2) the duty to minimize taxes.' 2 The duty

7. See infra notes 10-16 and accompanying text.8. See Freeland, Maxfield & Sawyer, Estate and Trust Distributions of Property in Kind After the

Tax Reform Act of 1984, 40 TAx L. REy. 449, 457 n.29 (1985); Raattama & Sawyer, Interaction ofthe New I.R.C. § 643(e) Election and Florida's Equitable Adjustment Doctrine, FLA. B.J., Oct. 1985, at

97 (suggesting such an adjustment may be necessary).

9. See infra §III.

10. For a comprehensive discussion of the equitable adjustment doctrine, see Blattmachr, The

Tax Effects of Equitable Adjustments: An Internal Revenue Code Odyssey, 18 INST. ON EST. PLAN. 1400-

1415 (1984); Carrico & Bondurant, Equitable Adjustments: A Survy and Analysis of Precedents and Practice,

36 TAx LA.w. 545 (1983); Dobris, Equitable Adjustments in Postmortem Income Tax Planning: An Unremitting

Diet of Warms, 65 IowA L. REv. 103 (1979).

11. See sources cited supra note 10.

12. Generally the duties of a trustee and personal representative are comparable, with the

exception of a few minor variations. The primary duties found applicable to the fiduciary are as

follows:

(1) The duty to use ordinary skill and prudence in the management of the trust or estate.

(2) The duty of loyalty, requiring the executor to administer the estate for the benefit of

creditors first and beneficiaries second. The trustee is required to administer trust property

for the benefit of the beneficiary. (3) The duty to not delegate. The fiduciary is under a

duty to personally perform duties of his office and cannot transfer administration of the

trust to another person. However, the trustee can delegate performance of certain acts

which it is unreasonable to expect him or her to perform. (4) The duty to keep accounts.

(5) The duty to furnish information regarding the nature and amount of trust property

at the request of the beneficiary. (6) The duty to take and keep control of trust property.

(7) The duty to make trust property productive. (8) The duty to pay income to the

beneficiary as provided by the trust. (9) The duty of impartiality when dealing with be-

neficiaries. (10) The duty of co-fiduciaries to participate in the administration of the trust

or estate and use reasonable care to prevent a co-fiduciary from committing a breach of

trust. (11) The duty to resist revocation of a trust where the trust instrument provides for

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of impartiality requires the fiduciary to act impartially toward beneficiaries andprohibits sacrificing the interest of one beneficiary by making a tax electionthat benefits another. 13 The duty to minimize taxes is derived from the fidu-ciary's duty to conserve trust or estate assets and to make the property rea-sonably productive. 14

Courts and legislatures have not given extensive attention to the equitableadjustments doctrine. Therefore, there is a lack of uniformity in its application. 15

This article will not address all situations in which the doctrine might arise butwill focus on those adjustments especially relevant to the analysis of an ad-justment in the context of a section 643(e) election. 16

A. The Warms Adjustment

The earliest reported case applying the equitable adjustment doctrine wasIn re Warms' Estate.'7 In Warms, the executor elected, pursuant to section 642(g),to deduct administration expenses on the estate's income tax return rather thanas an estate tax deduction. Under fiduciary accounting rules, administrationexpenses were paid out of principal of the residuary estate. Thus, the incometax deduction benefitted the income beneficiary while the remainderman borethe economic burden of expenses. In addition, estate taxes increased as a resultof not deducting administration expenses on the estate tax return. The additionaltax was paid from principal. The court determined an adjustment was warrantedand chose to have the income account reimburse the principal account forincreased estate taxes resulting from use of the expenses as income tax deduc-tions rather than estate tax deductions.' 8

revocation only with the consent of the trustee. (12) The duty to preserve trust property.(13) The duty to take all reasonable steps to enforce claims. (14) The duty to act reasonablyin defending claims against the trust or estate. (15) The duty to keep trust property separatefrom the trustee's own property and property of other trusts, and to earmark the trustproperty as property of the trust.

See EST. & TRUST PRAc. & FID. REsP. (IBP) 35,501 - 35,515.17 (1979); G. BOGERT & G. BOGERT,HANDBOOK OF THE LAW OF TRUSTS §S 93-124 (5th ed. 1973).

13. See, e.g., Howe v. Earl of Dartmouth, 32 Eng. Rep. 56 (1802); see also G. BOGERT &G. BOGERT, supra, note 12, at S 106; A. ScoTT, THE LAw OF TRUSTS 5 183 (3d ed. 1967); Dobris,supra note 10, 107-08.

14. See G. BOGERT & G. BOGERT, supra note 12, at S 101; A. Sco-r, supra note 12, at S181; Dobris, supra note 10, at 107-08.

15. See Carrico & Bondurant, supra note 10 (analyzing existing case and statutory law).16. See Blattmachr, supra note 10, at 1402 (identifying ten situations where courts have

made equitable adjustments).17. 140 N.Y.S.2d 169 (Sur. Ct. 1955).18. Id. at 171. The special guardian for the instant remainderman argued that administration

expenses should be charged to the income account. The court rejected the argument, reasoningthat the source of payment of expenses does not change because expenses were charged to incomerather than principal. Id. at 170.

The following example illustrates how a Warms adjustment might arise. Assume an estate withtaxable income of $100,000 and taxable estate, without regard to administration expenses, of $500,000.Additionally, tax rates for both income and estate taxes are 50% and administration expenses are

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Courts in other states have also invoked the Warms "adjustment." 9 Ad-

ditionally, it is local practice in some states to make such adjustments.2 0 Al-though there has been little legislative activity in the equitable adjustments area,at least three states have statutes allowing Warms adjustments.2 1 New York andMaryland have similar statutes requiring adjustment- without a need to incor-porate the statutory power by reference, provided the will expresses no provision

to the contrary.2 2 Connecticut takes a different approach, permitting specifiedfiduciary powers to be incorporated by reference in wills and trusts.Y One suchpower directs the fiduciary to claim certain administration expenses, casualty

losses, and other expenses to achieve the lowest overall tax liability for the estate

and beneficiaries. 24 An adjustment is required when the fiduciary's election

results in a greater portion of estate tax being paid from and charged to principalthan if a contrary election had been made.25

Following Warms, courts faced questions of whether adjustments should bemade when the section 642(g) election affects marital and nonmarital benefi-ciaries. The election affects the marital share when the bequest is dependent

on the size of the estate after deductions for administration expenses or when

$25,000. If the administration expenses are deducted on the estate return, the estate tax will be$237,500 (as shown below). However, if expenses are deducted on the income tax return, estatetaxes will be $250,000 with income taxes' reduced by $12,500 (as shown below).

No Section 642(g) Section 642(g)Election Election Made

Taxable Estate(Before Adm. Exp) $500,000 $500,000Adm. Expense Deduction ( 25,000) --

Taxable Estate 475,000 500,000Tax Rate x 50% x 50%Tax $237,500 $250,000

The principal account bears the burden of paying administration expenses even when deductionsbenefit the income beneficiary pursuant to a 5 642(g) election. The income account would berequired to reimburse principal for the $12,500 increase in estate taxes resulting from the § 642(g)election.

19. See In re Bixby's Estate, 140 Cal. App. 2d 326, 295 P.2d 68 (1956) (adoption of "Warmsadjustment" in California); In re Veith's Estate, 26 Fla. Supp. 145 (Dade County Ct. 1965) (samein Florida); In re Keht's Estate, 23 Fla. Supp. 133 (Palm Beach County Ct. 1964) (same); In reBell's Estate, 8 Ches. Co. Rep. 21 (Orphan's Ct. 1956) (same in Pennsylvania), aff'd, 393 Pa.623, 144 A.2d 843 (1958); Rhode Island Hosp. Trust Co. v. Sanders, 84 R.I. 347, 125 A.2d 100(1956) (same in Rhode Island).

20. See Carrico & Bondurant, supra note 10 (discussing local practices in Colorado, Georgia,Illinois, Kentucky, Massachusetts, Nevada, North Carolina, Oregon and Wyoming).

21. Connecticut, Maryland and New York. See infra notes 22-23.22. MD. ESTATE & TRUST CODE ANN. § 11-106(a) (1974); N.Y. EST. POwERS & TRUSTS LAW

5 11-1.2(A) (McKinney Supp. 1986).23. CONN. GEN. STAT. ANN. § 45-100(e)(35)(B) (West 1981).24. Id.25. Id.

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UNIVERSITY OF FLORIDA LA W REVIEWV

there is a maximum marital deduction dause. With the exception of one case,the courts have refused to require adjustment in these circumstances. 26

B. The Rice Adjustment

Under Subchapter J, the taxable income of an estate or trust will be affectedby the computation of DNI. 27 Section 643(a) defines DNI as taxable incomeof the estate or trust computed with certain modifications. 28 One of the mod-ifications is an exclusion for capital gains allocated to corpus and not actuallydistributed, required to be distributed, or permanently set aside for charity. 29

When a fiduciary sells an asset, the expenses attributable to the sale, suchas commissions and state capital gain taxes, are allocated to principal underfiduciary accounting rules." These expenditures, however, reduce DNI evenwhen payable from principal.3' These deductions reduce income allocable toprincipal only when they exceed DNI. 3 Congress expressly provided for thisresult so that deductions paid from corpus would not go to waste.3 3 However,the effect of the allocation deprives principal, the source giving rise to thedeductible expenditure, of the tax benefit of the deduction in years when it hastaxible gain.

For example, assume a trust has taxable ordinary income of $25,000 anda capital gain of $5,000, along with $3,000 of deductions attributable to acapital gain. The deduction will reduce ordinary income but not capital gain.When a fiduciary makes a sale, recognizing gain and generating deductibleexpenses allocable to corpus, an unfair allocation is automatically made throughinteraction of the DNI system and fiduciary accounting rules. Contrary to thediversion remedied by the Warms adjustment, this diversion is not the resultof a fiduciary's election; arguably, then, no adjustment is needed. 34 No statehas adopted a statute allowing for adjustment in this situation. Moreover, theUniform Principal and Income Act requires no adjustment. 35 Presently, thereis a split of authority concerning whether an equitable adjustment is required

26. See In re Veith's Estate, 26 Fla. Supp. 145 (Dade County Ct. 1954) (adjustment notrequired); In re McTarnahan's Estate, 27 Misc. 2d 13, 202 N.Y.S.2d 618 (Sur. Ct. 1960) (same);In re Inman's Estate, 22 Misc. 2d 573, 196 N.Y.S.2d 369 (Sur. Ct. 1959) (same). But see In reLevy's Estate, 9 Misc. 2d 561, 167 N.Y.S.2d 16 (Sur. Ct. 1957) (adjustment required).

27. See I.R.C. § 643 (West 1986).28. Id. S 643(a).29. Id. S 643(a)(3); Treas. Reg. 5 1.643(a)-3 (West 1986).30. See, e.g., FLA. STAT. § 738.13(3) (1985); N.Y. EST. PowERs & TRUsT LAW S 11-2.1(d)(1)

(McKinney 1967).31. See Treas. Reg. § 1.643(d)-2 (West 1986) (illustration of the § 643 provisions).32. See Moore, Conflicts in Post-Mortem Planning After the Tax Reform Act, 12 INST. ON EST.

PLAN. §5 600-609 (1978).33. See Dobris, supra note 10, at 120.34. See infra notes 42-44 and accompanying text.35. REv. UNIF. PRINCIPAL AND INCOME ACT, 9§ 5, 13, 7B U.L.A. 145 (1962).

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from the income account to reimburse principal for an increase in income taxesborne by the principal account by reason of the Code.36

Rice Estate" involved a sale by the trustee in which gain of $400,000 wasrealized, resulting in a capital gain tax of approximately $100,000. Deductibleattorney's fees of $202,000 were charged to principal, while the tax benefit ofthese fees inured to the income beneficiary.38 Since there was a fifty percentcapital gain deduction in effect at the time of the sale,39 that deduction, com-bined with the attorney's fees, would have reduced taxable gain to zero. Thecourt ordered the income account to reimburse the principal account for theincrease in capital gains taxes borne by the corpus as a result of expenseallocations to the benefit of the income account as required under SubchapterJ.40 In making its decision, the court cited Warms as precedent, disregardingthe absence of any fiduciary election as to whether principal expenditures wouldreduce DNI. 41

However, in In re Estate of Dick,42 the New York Surrogate Court refusedto make the adjustment required by the Rice court, reasoning that Warms didnot justify an adjustment. The court emphasized that Warms involved a fidu-ciary's exercise of a statutory election while in the case before it the trusteewas not granted an option.43 Dick was followed by a Florida court in In reKent's Estate.44

C. Trapping Distributions

A common technique employed to tax estate income at lower marginal brack-ets is the "trapping distribution." 45 The trustee often accomplishes income split-

36. See infra notes 37-44 and accompanying text. See also notes 60-69 and accompanying text.37. 8 Pa. D. & C.2d 379 (1956).38. Id. at 412.39. The Tax Reform Act of 1986 repealed the 60% capital gain deduction formerly provided

under § 1202. Repeal is effective for taxable years beginning after December 31, 1986. However,the Tax Bill did not change characterization of gain as capital or ordinary. Tax Reform Act of1986, Pub. L. No. 99-514, § 301(a), 1986 U.S. ConE CoNG. & ADMIN. NEws (100 Stat.) 132.However, the maximum capital gain rate is 28% for taxable years beginning in 1987 and thereafter.Int. Rev. Code of 1986 § 1(j).

40. 8 Pa. D. & C. 2d at 413.41. Id. at 414.42. 29 Misc. 2d 648, 218 N.Y.S.2d 182 (Sur. Ct. 1961).43. Id. at 650, 218 N.Y.S.2d at 184; see also New England Merchants Nat'l Bank v. Converse,

373 Mass. 639, 369 N.E.2d 982 (1977) (adjustments refused under facts similar to Dick becauseadjustment not practical).

44. 23 Fla. Supp. 133, 136 (Palm Beach County. Ct. 1964) (fiduciary not required to cureinequities created by interaction of tax law with principles of estate accounting). But see Dobris,supra note 10, at 14041:

The Dick opinion is wrong, principal should be reimbursed for lott use of a deduction.Requiring an adjustment is the proper course of action for a court when a fiduciary'sdiscretionary act has caused an adjustable inequity or when the allocation of the benefitsand burdens of mandatory action is unjust under standard allocations rules.45. For a detailed discussion on "trapping distributions" see Blattmachr, supra note 10, at

1403.3; Carrico & Bondurant, supra note 10, at 563-67 (review of statutory and judicial responses

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ting by making a partial distribution of estate principal to a trust. Normally,this situation arises when the income beneficiary of a testamentary trust isentitled to all accounting income earned by the estate during administration,even though income may not be paid out to the trustee until estate adminis-tration is completed. For tax purposes, the distribution of principal constitutesincome to the trust and is deductible by the estate to the extent of DNI,4 eventhough the distribution is principal on the books of the estate and is allocatedto principal on the books of the trust. 7 The distribution, therefore, even ifprincipal, will have the effect of shifting DNI from the estate to its beneficiary,the trust. However, because the trust may have no accounting income to bedistributed, DNI will be trapped in the trust as corpus. This result occursbecause the income beneficiary of the trust is only entitled to distributions ofincome, as opposed to corpus, and the trust is unable to distribute all its DNIfor the year. The trust will be required to pay tax on trapped DNI receivedfrom the estate. 4

' Thus, two entities, the estate and the trust, will share theincome tax burden of the estate's DNI, presumably reducing the overall taxliability.

If the trust received income rather than corpus, it would be able to distributeit to the income beneficiary and thus receive a section 661 deduction, to theextent of DNI. As a result of the trapped DNI being taxable to the trust,principal is reduced by taxes to the detriment of the principal beneficiaries.Thus, when income of the estate actually incurring the income tax is laterdistributed to the income beneficiary, it may be received tax free.4 9

In In re Estate of Holloway,50 the New York Surrogate Court faced the issueof whether an equitable adjustment was warranted in a situation involving atrapping distribution. The court held the income account had to reimburse theprincipal account for income taxes paid by the trust on the trapped distribu-tion.-" The Surrogate Court first denied the adjustment, reasoning that section13(c)(4) of the Revised Uniform Principal and Income Act required principal

in this area as well as drafting solutions); Cohan & Frimmer, Trapping Distributions: The Trap thatPays, 112 TR. & EsT. 766 (1973); Dobris, supra note 10, at 127-30.

46. See I.R.C. §§ 661-662 (West 1986).47. See Blattmachr, supra note 10, at 1403.3.48. Id.49. The following example illustrates how a trapping distribution will result in an equitable

adjustment. Assume an estate distributes $20,000 of principal to a previously unfunded testamentarytrust created under a will. The estate had income of $50,000 and made no other distributionsduring the year. Beneficiary A is entitled to principal and beneficiary B is entitled to all incomeof the estate. The $20,000 distribution will carry out DNI and reduce the estate's income to $30,000because of 5 661. The trust will be taxed on $20,000 because it may only distribute income toB. Assuming a tax rate of 30%, trust principal will be reduced by the $6,000 of taxes. If, in thenext year, the estate distributes income to B, assuming the estate has no additional income, B willreceive $20,000 free of tax. Under principles of Holloway, the income account would be requiredto reimburse principal in the amount of $6,000.

50. 67 Misc. 2d 132, 323 N.Y.S.2d 534 (Sur. Ct. 1971), modified, 68 Misc. 2d 361, 327N.Y.S.2d 865 (Sur. Ct. 1972).

51. 68 Misc. 2d at 366, 327 N.Y.S.2d at 869.

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to pay all taxes on property allocated to principal.5 2 However, on rehearing thecourt reversed its earlier decision, stating that based on purely equitable prin-ciples, the burden of income taxes should be charged to the account into whichthe item goes.53 Holloway and Rice both support the proposition that, even whennon-elective tax procedures alter beneficiaries' interests, a state court may ov-erride statutory principal and income allocation rules and order an adjustment.

D. Disproportionate Distributions

When there is more than one beneficiary of an estate and the fiduciarymakes a disproportionate distribution, a disproportionate amount of DNI maybe allocated to that beneficiary and a disproportionate amount of income willbe reportable by such beneficiary. 54 Unless an adjustment is made, each of theremaining beneficiaries will continue to be entitled to their proportionate shareof income unreduced by any income tax (or by less tax than if the dispro-portionate distributions had not been made). An inequity results when thebeneficiary receiving the disproportionate distributions pays income tax on in-come receipts allocable to another beneficiary. The inequity exists due to thescheme of Subchapter J: distributions are deemed to carry out estate incomefor the year without regard to character as current income or principal.5 How-ever, for fiduciary accounting purposes, estate income is distributed on a prorata basis with reference to the respective interests of the different beneficiariesin estate principal .

6

Consider an estate with principal of $100,000, income of $10,000, and tworesiduary beneficiaries, A and B, each entitled to equal portions of income andprincipal. A and B are each entitled to $5,000 of income for the year. Suppose$15,000 of principal is distributed to A with no distribution to B. A is taxedon the full $10,000 of income because A is deemed to carry out DNI althoughB is still entitled to B's share of income.5 7 Later, when income is distributedto A and B, B's share will be tax free and A will have borne the burden ofB's share of taxes on the income."'

Unlike trapping distributions, there is little tax purpose for disproportionatedistributions. They usually result from thoughtless or ill-advised distributionsby the fiduciary or from a distribution to a dependent beneficiary. 59 In In reSalesky's Estate,60 the Pennsylvania Orphans Court held that a widow, electingto take her dower share against the will, was entitled to reimbursement for

52. 67 Misc. 2d at 133-34, 323 N.Y.S.2d at 535.53. 68 Misc. 2d at 365, 327 N.Y.S.2d at 869.54. See I.R.C. § 662 (West 1986). With respect to a trust, this may not be true as a result

of the separate share rules. Id. § 663(c).55. See id. §§ 661-662.56. See, e.g., N.Y. EsT. Powms & TRusts LAw § 11-2.1(a)(c) (McKinney 1967).57. See I.R.C. §5 652, 662 (West 1986).58. See Carrico & Bondurant, supra note 10, at 571-76; Dobris, supra note 10, at 130-36.59. See Dobris, supra note 10, at 133 nn.177-78 and accompanying text. However, on certain

occasions the lower tax bracket of the beneficiary may result in an overall tax savings.60. 15 Pa. Fiduc. 213 (Orphan's Ct. 1965).

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having to bear a disproportionate income tax burden on account of non-prorata distributions.6 Similarly, in In re Estate of Cooper,52 a Florida court heldthat a widow was entitled to reimbursement for additional taxes borne by her.However, in Cooper there was a prior agreement in which the widow reservedthe right to reimbursement, 63 thus the decision is questionable precendent.

E. Depreciation Deductions Inuring to the Benefit of the Income Beneficiary W'VhileIncreasing the Principal Bendficiary's Tax Burden

Pursuant to section 167(h), if no reserve for depreciation is maintained, thedepreciation deduction is allocated between beneficiaries and the trust or estateon the basis of income allocable to each.64 Therefore, if the income beneficiariesreceive all the income and there is no provision for allocation in the trustinstrument, depreciation only reduces the income beneficiary's tax liability. Later,when the asset is sold, a larger gain will be realized because of the reductionin basis for depreciation. 5 Under normal fiduciary accounting, receipts of thesale are allocable to corpus and the principal beneficiary will bear the burdenof tax on any gain or recapture, despite the income beneficiaries receiving thebenefit of depreciation deductions.

In Matter of Pross,66 the court, relying on Holloway,67 held that the incomebeneficiary would have to bear the burden of capital gains taxes when theincome beneficiary received the benefit of depreciation. 68 While Pross has beencited as authority for an equitable adjustment where no fiduciary discretion is

61. Id. at 215-16. The estate's income tax savings resulting from the distribution was ap-proximately $15,000 while the widow paid approximately $10,000 in taxes on the distribution.

62. 186 So. 2d 844 (Fla. 1966).63. Id. at 844-45.64. See I.R.C. 5 642(e) (West 1986).65. Id. 5 1016(a)(2). For example, suppose a trust holds a capital asset with a depreciable

basis of $100,000. The trust does not provide for allocation of depreciation. In Year 1, the trustearns income of $20,000 which it distributes to B, the income beneficiary, and depreciation of$15,000 is allowable and is allocated entirely to B. If, on the first day of Year 2, the asset is soldfor $100,000, a taxable capital gain of $15,000 results (amount realized of $100,000 less adjustedbasis of $85,000). Gain under normal fiduciary accounting rules is taxable to the principal account.Assuming tax on the gain is $5,000, the principal account will be reduced by $5,000 although theincome beneficiary received the benefit of depreciation. Under a Warms adjustment, the incomeaccount should be required to reimburse principal for the capital gains tax of $5,000.

66. 90 Misc. 2d 895, 396 N.Y.S.2d 309 (Sur. Ct. 1977).67. See supra notes 50-53 and accompanying text.68. 90 Misc. 2d at 898, 396 N.Y.S.2d at 311. Surrogate Brewster in citing Holloway stated:If the trustees set aside the amount deducted for depreciation to preserve principal infulfillment of their duty, the reserve would be wholly applicable to principal and the sourceof capital gain. However, in this case, there was no reserve. The capital gain is nothingmore than a paper entry which has come about by reason of the depreciation deductionhaving reduced the base of the property below the amount realized upon the foreclosure.There was no addition to appreciation of or replacment for the trust principal .... Tothe extent that the income beneficiary received the benefits of the deduction for depreciationwithout any concomitant benefit to trust principal, equity requires that the charge for thecapital gains tax be placed on the person receiving the capital gain.

Id. at.898, 396 N.Y.S.2d at 311.

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involved, the fiduciary under the New York version of the Revised UniformPrincipal and Income Act elected not to establish a depreciation reserve. 69 There-

fore, Pross is of questionable validity.

F. Sale of Trust or Estate Assets

As previously discussed, fiduciary discretion in selling trust or estate assets

could result in the shifting of benefits in the RiceDick" scenario. In determiningwhether to sell or distribute an asset in kind, the fiduciary is faced with another

more general dilemma. If the fiduciary distributes assets in kind, the beneficiary

will receive either a section 1014 basis or a fair market value date of distributionbasis. If assets are distributed to satisfy a pecuniary bequest, the basis to the

beneficiary will be fair market value. However, the trust or estate will recognize

a gain. 71 If assets are distributed in a specific distribution, their income taxbasis to the beneficiary will be a section 1014 basis;72 however, no gain is

recognized.73

Conversely, if assets are sold at a gain, the corpus of the trust or estatewill normally bear the burden of capital gains taxes. Thus, the fiduciary mustchoose between distributing the asset with the possibility of unrealized appre-

ciation or selling the asset at the expense of principal beneficiaries. Courts havegenerally held that trustees have the power to sell, absent a contrary provision. 74

At present, no statutory or common law authority exists directly supporting an

adjustment for beneficiaries suffering disproportionate income tax burdens be-cause of sales. However, several analogies support such an adjustment. Theremainder of this paper will develop these analogies.

III. SECTION 643(e)

A. The General Rule

The Deficit Reduction Act of 1984 added section 643(e) to control tax con-

sequences to estates and trusts and their beneficiaries upon in kind distribu-tions. 75 Under the general rule, when the personal representative or trustee

69. Id.; see N.Y. EsT. Powaas & TRUSTS LAW § 11-2.1(a) (McKinney 1967); REv. UNIF.

PRINCIPAL & INco.iE ACT § 2, 7B U.L.A. 151 (1962).70. See supra notes 27-44 and accompanying text.71. Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940); Rev. Rul. 60-87, 1960-1 C.B.

286.72. I.R.C. § 1014 (West 1986); Treas. Reg. § 1.1014-1, 3 (West 1986).73. I.R.C. § 663(a) (West 1986).74. See G. BOGERT & G. BOGERT, supra note 12, at § 133. A trustee's power to sell trust

assets is implied in equity whenever such power is necessary or useful in carrying out the trust,even though the trust instrument is wholly silent on the subject of sale. See, e.g., Preston v. SafeDeposit & Trust Co., 116 Md. 211, 81 A. 523 (1911); Garesche v. Levering Inv. Co., 146 Mo.436, 48 S.W. 653 (1898); Clark v. Fleischman, 81 Neb. 445, 116 N.W. 290 (1908); Crown Co.v. Cohn, 88 Or. 642, 172 P. 804 (1918); Wisdom v. Wilson, 59 Tex. Civ. App. 593, 127 S.W.1128 (1910).

75. For a detailed discussion of new § 643(e) and its impact, see Aucutt, Tax Planning for

11



UNIVERSITY OF FLORIDA LA W REVIEW

makes no election, gain or loss is not recognized to the trust or estate uponan in kind distribution.7 6 When no election is made, the beneficiary's basis indistributed property will equal the property's adjusted basis in the trust or estate,adjusted by any gain or loss recognized by the trust or estate. 77 Thus, thebeneficiary norrmally gets a carryover basis. The amount distributed for purposesof sections 661 and 662 is equal to the lesser of the property's adjusted basis,adjusted for gain or loss recognized by the trust or estate, or fair market value.78

B. The Elective Rule

Under the elective rule, gain or loss is recognized to a trust or estate uponan in kind distribution as if the property had been sold at fair market value.79

For purposes of sections 661(a)(2) and 662(a)(2), the amount distributed is thefair market value of the property.80 The beneficiary's basis is the adjusted basisof the property to the trust or estate adjusted by any gain or loss recognizedon the distribution. By requiring the trust or estate to recognize gain or lossunder the elective rule, Congress has alleviated the prior law's distortion, whichallowed a beneficiary a fair market value basis while the trust or estate rec-ognized no gain or loss. 81

C. In Kind Property Distributions Where Section 643(e) Is Not Applicable

Before determining application of the equitable adjustment doctrine to asection 643(e) election, one must first determine if section 643(e) applies to thetransaction under consideration. As the subsequent discussion will illustrate, thescope of section 643(e) is quite narrow.

Section 643(e) should not, apply to the following in kind distributions:

In-Kind Distributions Increased by New Special Election, 62 J. TAx. 48 (1985); Freeland, Maxfield &Sawyer, Estate and Trust Distributions of Property In-Kind After the Tax Reform Act of 1984, 40 TAx L.REv. 449 (1984); Kelly, Treatment of Property Distributed In-Kind Under the Tax Reform Act of 1984,63 TAXEs 423 (June 1985).

76. Gain or loss may result when no election is made in two situations: (1) where the assethas a mortgage in excess of basis, and (2) upon distribution of an installment obligation pursuantto § 453B. Freeland, supra note 75, at 475. However, no S 1245 or § 1250 gain should be recognizedin a distribution in which no gain or loss is otherwise recognized. I.R.C. S 1245(b)(1)-(2) (West1986); Treas. Reg. S 1.12454(a)-(b) (West 1986); I.R.C. S 1250(dXl)-(2) (West 1986); Treas. Reg.S 1.1250-3(a)-(b) (West 1986); see Freeland, supra note 75, at 467-69.

77. I.R.C. § 643(e)(1) (West 1986).78. Id. § 643(e)(2).79. Id. § 643(e)(3). The Tax Reform Act of 1986 amended S 643(e)(3)(B) to provide that

election under S 643(e)(3) shall apply to all distributions made by the estate or trust during ataxable year. Tax Reform Act of 1986, Pub. L. No. 99-514, § 1806(b), 1986 U.S. CODE CoNo.& ADMIN. NEws (100 Star.) 726. Thus, an election to recognize gain or loss cannot be made oneach separate distribution, as the language of the Tax Reform Act of 1984 seems to provide. Section643(e)(3)(B) continues to provide that election must be made on the tax return for the taxableyear of the distribution.

80. I.R.C. § 643(e)(3)(A)(iii).81. See Treas. Reg. 9 1.661(a)-(2)(t) (West 1986).

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(1) Distributions described in section 663(a).

(2) In kind distributions of property in satisfaction of pecuniary be-quests not within section 663.

(3) Distributions of specific property or cash bequests directed by theterms of the instrument and paid in more than three installments.

(4) Distributions described in sections 651(a) and 661(a)(1).

(5) Distributions of property governed by section 691.

(6) Distributions when the grantor is treated under sections 671-78as the owner of a trust.

1. Distributions Within Section 663(a)

Section 663(a) provides that distributions within that section shall not beincluded as amounts falling within sections 661(a) or 662(a). Therefore, sincesections 661 and 662 are not applicable, the estate or trust receives no deductionand the beneficiary treats amounts received as a section 102(a) gift. Conse-quently, section 643(e)(4) provides an exception for distributions described insection 663(a). Section 663(a) applies to the following distributions:

(1) Specific bequests or gifts of a specific sum of money or propertypaid or credited in not more than three installments.8 2

(2) Amounts paid or subsequently set aside that qualify for charitablededuction under section 642(c).8

(3) Amounts distributed to which section 651 or 661 applied in apreceding taxable year, because the distribution was made when requiredin a previous year.8 4

2. Distributions in Satisfaction of Pecuniary Bequests, More than ThreeInstallments, and Under Sections 651(a)(1) and 661(a)(1)

Section 643(e) will not apply to in kind distributions of property used tosatisfy pecuniary bequests not within section 663.85 An example of such a dis-tribution occurs when a decedent leaves his spouse fifty percent of the adjusted

82. I.R.C. S 663(a)(1) (West 1986).83. Id. § 663(a)(2).84. Id. § 663(a)(3).85. See Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940); Treas. Reg. § 1.663(a)-l(b)(1)

(West 1986); H.R. REp. No. 861, 98th Cong., 2d Sess. 870, reprinted in 1984-3 C.B. 124.

1986] 823

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gross estate and the executor uses appreciated property to satisfy the bequest.86

Gain will be recognized and section 643(e) will not apply because there is adeemed cash distribution rather than a property distribution.87

Distribution of a specific sum of money or item of property according toan instrument and paid or credited in more than three installments will alsofall outside section 663(a)(1). However, section 643(e) should not apply becauseany gain on appreciated property results because of satisfaction of the obligationwith appreciated property. 88

Additionally, section 643(e) should not apply to distributions under sections651(a)(1) and 661(a)(1). These are required distributions and if appreciatedproperty is used to satisfy them, gain will be recognized. 89

3. Property Representing the Right to Receive Income in Respect ofDecedent and the Grantor Trust Rules

Under section 691, income in respect of a decedent (IRD) is taxable to theestate or beneficiaries upon receiving a distribution." IRD generally includesamounts to which the decedent was entitled as gross income but that were notproperly includible in taxable income for a previous year or the taxable yearending with decedent's death because of the method of accounting used.9 Thegeneral subchapter J rules regarding distributions from trusts and estates, in-cluding section 643(e), are not applicable to distributions of rights to IRD.92

Thus, for example, if an estate distributes the right to a decedent's accruedsalary, distribution of that right will not invoke section 643(e). Instead, section691 will apply and the salary is income to the recipient upon receipt.

Section 643(e) also will not apply to the extent the grantor trust rules ofsections 671-678 treat the grantor or another person as owner of the trustproperty.9 3 The grantor trust rules override sections 661 and 662 and rendersection 643(e) inapplicable.

IV. APPLICATION OF THE EQUITABLE ADJUSTMENT DOCTRINE TO A SECTION

643(e)(3) ELECTION

As previously discussed, section 643(e) will not apply to many in kind dis-tributions because other Code provisions or principles of common law apply 4

86. Treas. Reg. § 1.663(a)-l(b)(1) (West 1986).87. See Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940).88. Id.89. See Rev. Rul. 67-74, 1967-1 C.B. 194; I.R.C. § 643(e)(2) (West 1986). But see Treas.

Reg. § 1.661(a)-2(c) (West 1986); Rev. Rul. 68-195, 1968-1 C.B. 305 (West 1986).90. I.R.C. § 691(a) (West 1986).91. Treas. Reg. 9 1.691(a)-(1) (West 1986).92. Id. § 1.691(a)-4(b); Rollert Residuary Trust v. Commissioner, 80 T.C. 619, 644 (1983),

aff'd, 752 F.2d 1128 (6th Cir. 1985); Freeland, supra note 75, at 463.93. See Rev. Rul. 67-241, 1967-2 C.B. 225; Treas. Reg. S 1.671-2(d) (West 1986).94. See supra notes 82-84 and accompanying text.

824 [Vol. Xxxviii

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A. In Kind Property Distributions from Trusts

Section 643(e) should apply under the following fact pattern. Assume A andB are beneficiaries of a written trust. A has a right to discretionary distributionsof trust income and corpus and B is entitled to the remainder of trust corpusat A's death. For calendar year 1986 the trust has DNI of $100,000. Thetrustee makes a discretionary distribution to A of a capital asset with a fairmarket value (FMV) of $150,000 and a basis of $75,000.

Under the general rule, the trust recognizes no gain or loss on distributionof the capital asset to A (see Table I below). A has a basis of $75,000 in thedistributed property (the asset's adjusted basis to the trust).95 The "amountdistributed" for purposes of sections 661(a)(2) and 662(a)(2) is $75,000 (thelesser of the basis of the property to A or FMV).9 6 Assuming the trust doesnot distribute any income to A during the year, A has taxable income of $75,000as a result of the distribution.97 If A immediately sells the property for $150,000,A will be taxed on $75,000 gain remaining in the property. The trust willreceive a distribution deduction of $75,00091 and consequently will be subjectto tax on $25,000 of undistributed DNI.99

TABLE I

No Section 643(e)(3)Election Made Election Made

TRUST

DNI $100,000 $100,000Capital Gain - 75,000

Total $100,000 $175,000Distribution Deduction (75,000) (100,000)Section 1202 Deduction0 " -- ( 22,500)Taxable Income 25,000 52,500Tax Rate (approx.) 101 x .25 x .35Tax $ 6,250 $ 18,375

95. I.R.C. 5 643(e)(1) (WVest 1986).96. Id. § 643(eX2).97. Id. § 662(a)(2).98. Id. § 661(a)(2).99. DNI of $100,000 less the $75,000 distribution deduction.

100. See supra note 39 (discussion of the repeal of § 1202 for taxable years beginning afterDecember 31, 1986).

101. The Tax Reform Act of 1986 changed tax rates applicable to trusts and estates signif-icantly. For taxable years beginning in 1987, the top rate is 38.5% for taxable income in excessof $15,150. For taxable years beginning in 1988, the top rate is 28% for taxable income exceeding$5,000. See Tax Reform Act of 1986, Pub. L. No. 99-514, § 101, 1986 U.S. CODE CONo. &ADMIN. NEws (100 Stat.) 12 (amending I.R.C. § l(e) and adding Int. Rev. Code of 1986 § l(g)& (h)).

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TABLE I (continued)

NoElection Made

Section 643(e)(3)Election Made

BENEFICIARY (A)Section 662 IncomeCapital Gain

TotalSection 1202 DeductionTotal Taxable IncomeTax Rate (Assumed)1 2

Tax

OVERALL TAX LIABILITY

TrustBeneficiary (A)

$ 75,00075,000

$150,000(22,500)

$127,500x .50

$ 63,750

$ 6,25063,750

$ 70,000

$100,000

$100,000

$100,000x .50

$ 50,000

$ 18,37550,000

$ 68,375

On the other hand, if a section 643(e)(3) election is made, different con-sequences occur (see Table I). The trust recognizes a $75,000 capital gain ondistribution of the property to A.'"3 The beneficiary would receive a $150,000basis in the property ($75,000 basis to the trust adjusted for the $75,000 gainrecognized) 104 and the "amount distributed" for purposes of sections 661(a)(2)and 662(a)(2), and the beneficiary's basis in distributed property will be$150,000.105 However, the distribution's deduction to the trust under section661(a)(2), as well as taxable income to A under section 662(a)(2), is limited toDNI.

This brings to focus the question of whether capital gain recognized by thetrust increases DNI. The election does not automatically cause DNI to increase.If a section 643(e)(3) election results in capital gain in the year of terminationof the trust or estate, capital gain will enter the DNI computation. 10 6 Section643(a) ordinarily provides for capital gain exclusion from DNI. However, Treas-ury Regulation section 1.643(a)-(3) sets out three situations when capital gainsare included in DNI:

(1) Capital gains 'are allocated by the fiduciary to income under theterms of the trust instrument or local law either on the books or bynotice to the beneficiary.

102. This example assumes a taxable year ending December 31, 1986. The Tax Reform Actof 1986 reduced the top income tax rate for individuals significantly. The top marginal rate is38.5% and 28%, respectively, for taxable year 1987 and years beginning in 1988 and beyond.The maximum rate on capital gains beginning January 1, 1987 is 28%. Int. Rev. Code of 1986§1).

103. I.R.C. S 643(e)(3)(A)(ii) (West 1986).104. Id. S 643(eX1).105. Id. 5 643(e)(1), (e)(3)(A)(iii).106. Id. 5 643(a)(3); Treas. Reg. § 1.643(a)-3(a)(2) (West 1986).

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(2) Capital gains are allocated to corpus but actually distributed tobeneficiaries during the year.

(3) Capital gains are utilized under the terms of the instrument orin practice by the fiduciary in determining the amount to be distributed.

In the hypothetical, the first requisite above is not met, assuming the gov-erning instrument is silent as to allocation of capital gains and local law requiresallocation to corpus." 7 The second instance under the regulations requiringcapital gains to be included in DNI only applies if there is a distributionrequired by the governing instrument upon the happening of a specified event.10 8

In this hypothetical, no such condition for inclusion is present. The third in-stance under the regulations occurs when capital gains are utilized in deter-mining the amount distributed or required to be distributed. Under ourhypothetical, this requisite is not satisfied. Thus, under the hypothetical, thecapital gain of $75,000 is excluded from DNI. 09

Therefore, taxable income to A and the distribution deduction to the trustare limited to $100,000, the amount of DNI. A receives property with a $150,000basis but is only taxed on $100,000. In effect, A receives $50,000 in propertytax free. The trust, however, recognizes the full $75,000 gain. Thus, B, theremainder beneficiary, bears the tax burden because the tax reduces principalin the trust. At the same time, A receives the benefit of a $50,000 tax-freestep up in basis.

This hypothetical illustrates how a section 643(e)(3) election might benefitone beneficiary at the expense of another and creates an opportunity to applythe equitable adjustment doctrine. The consequences of a section 643(e)(3) elec-tion appear to be similar to the result in a Warms" ° type situation. Applyingthe Warms rationale, the trustee would be required to adjust the income accountby reimbursing principal for increased taxes to the trust resulting from thesection 643(e)(3) election. Referring to Table I, the election reduced combinedtaxes to the trust and beneficiary A but resulted in an increase in tax to thetrust of $12,125 (while A's tax was reduced by $13,750). Warms would requirethe trustee to transfer $12,125 from the income account to the principal account.Even after adjustment, A realizes a net reduction in tax liability as a result ofthe election and receives a $50,000 step up in basis.

The applicability of an adjustment to a section 643(e)(3) election is further

107. See, e.g., UNIF. PRINCIPAL & INCOME ACT 9 3(2), 7B U.L.A. 192 (1931); REv. UNIF.PRINCIPAL & INCOME ACT S 3(b)(1), 7B U.L.A. 155 (1962); see also Rev. Rul. 69-392, 1968-2 C.B.284.

108. See Treas. Reg. S 1.643(a)-3(d), examples (3), (4) & (5) (West 1986); Rev. Rul. 68-392,1968-2 C.B. 284.

109. See Rev. Rul. 68-392, 1968-2 C.B. 284; Priv. Ltr. Rul. 8,506,005 (Nov. 7, 1984), IRS- LTR. RULINGS REP. (CCH) No. 416 (Feb. 20, 1985); Priv. Ltr. Rul. 8,429,005 (Mar. 26, 1984),IRS - LTR. RULINCGS REP. (CCH) No. 386 (July 25, 1984); Priv. Ltr. Rul. 8,324,002 (Feb. 16,1983), IRS - LTR. RULINGs REP. (CCH) No. 329 (June 22, 1983); Priv. Ltr. Rul. 8,105,028 (Oct.28, 1980), IRS - LTR. RULINGS REP. (CCH) No. 206 (Feb. 11, 1981).

110. See supra notes 17-26 and accompanying text.

19861

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UNIVERSITY OF FLORIDA LAW.REVIEW

supported by Rice."' Although no fiduciary election was involved, the adjustmentresulted as a consequence of the exclusion of capital gains from DNI. In ad-dition, the section 643(e)(3) election, similar to a trapping distribution, is nor-mally made to minimize overall taxes of the trust or estate and its beneficiaries.Holloway, which required the income account to reimburse principal for tax paidon a trapped distribution, also supports adjustment after a section 643(e)(3)election.1

2

The applicability of an equitable adjustment with respect to a section 643(e)election may be compared with adjustments made when the fiduciary decidesto sell an asset and recognize gain, distributing proceeds rather than distributingthe asset in kind with unrealized appreciation.1 3 As pointed out earlier, nopresent authority directly authorizes an adjustment though, under Warms, itappears to be warranted. The exercise of a fiduciary's discretion to make asale of a trust asset or a section 643(e)(3) election may benefit one beneficiaryat the expense of another and create a situation in need of an equitable ad-justment.

In the previous hypothetical, if the facts remained the same but the trustwas required to distribute trust income to A, different consequences, as shownin Table II, result. By making an election, the combined tax liability of thetrust and A is reduced by $7,875. However, the tax liability of the trust is in-creased by $18,375. Thus, under the Warms rationale, the trustee would be re-quired to reimburse the principal account for $18,375. The income beneficiarymay argue for limiting the reimbursement amount to $16,250, the beneficiary's

TABLE II

No Section 643(e)(3)Election Made Election Made

TRUST

DNI $100,000 $100,000Capital Gain _ - 75,000

Total $100,000 $175,000Section 661(a)(1) Deduction (100,000) (100,000)Section 661(a)(2) Deduction -Section 1202 Deduction" 4 - (22,500)Taxable Income 0,000 $ 52,500Tax Rate1 5

_ - x .35Tax $ 0,000 $ 18,375

111. See 8 Pa. D. & C. 2d at 413.112. See 68 Misc. 2d at 365, 327 N.Y.S.2d at 869.113. See supra S II.F.114. See supra note 100.115. See supra note 101.

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TABLE II (continued)

NoElection Made

BENEFICIARY (A)Section 662(a)(1)Section 662(a)(2)Capital Gain

TotalSection 1202 DeductionTaxable IncomeTax Rate"16

Tax

OVERALL TAX LIABILITY

TrustBeneficiary (A)

$100,000

$ 75,000$175,000

(22,500)$152,500

x .50$ 76,250

$ 0,00076,250

$ 76,250

Section 643(e)(3)Election Made

$100,000

$100,000

$100,000x .50

$ 50,000

$ 18,37550,000

$ 68,375

tax reduction related to the election. Such an argument is not supported byWarms, which only focused on the increase in estate taxes resulting from a sec-tion 642(g) election, not decreases in estate income taxes inuring to the benefitof the party favoring the election.11 7

B. Effect of Ordinary Income Recognition Provisions

The above hypotheticals involved distribution of assets resulting in capitalgain recognition due to a section 643(e)(3) election. The inequitable conse-quences occur at least partially because capital gain is generally excluded fromDNI.118 However, when section 1245 or 1250 gain is recognized,11 9 DNI isincreased and partially eliminates the need for an equitable adjustment. Anadjustment would not be necessary because the distributee beneficiary wouldnot be getting a tax free step up in basis, since the amount taxable to thebeneficiary would also be increased by the sections 1245 and 1250 income.

In addition, when a trustee makes a section 643(e)(3) election, section 1239characterizes any gain recognized by related persons as ordinary income, pro-vided the distributed property is subject to depreciation in the distributee'shands.1 20 For purposes of section 1239, the trust and a beneficiary with more

116. See supra note 102.117. See Warms, 140 N.Y.S.2d at 171.118. See supra notes 39, 100-102.119. Sections 1245 and 1250 gain lurking in property distributed in kind should not be required

to be recognized in a distribution in which no gain or loss is otherwise recognized (i.e., where noS 643(e)(3) election is made). See I.R.C. SS 1245(b)(1),(2), 1250(d)(1),(2) (West 1986).

120. See id. $ 1239(a)-(b)(2).

1986]

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than a remote contingent interest are related persons. 2 1 However; section 1239does not apply to estates. 122 Therefore, to the extent section 1239 applies, or-dinary income will increase DNI and, as discussed with respect to sections 1245and 1250 recapture, section 1239 will partially or totally eliminate the need foran equitable adjustment. Likewise, a section 643(e)(3) election may result insection 1231 ordinary gain also increasing DNI and having an effect on anypossible equitable adjustment similar to sections 1245, 1250 and 1239.

Circumstances might warrant an equitable adjustment when the fiduciarymakes an election under section 643(e)(3) and capital loss is recognized. How-ever, this will only occur in an estate if section 267, regarding losses betweenrelated parties, disallows the loss when a trustee makes an election. 123

V. TAX EFFECT OF THE EQUITABLE ADJUSTMENT

Although beyond the scope of this paper, it should be noted that an eq-uitable adjustment as a result of a section 643(e)(3) election may have furthertax ramifications to the entity and beneficiary.12 For example, making an ad-justment could reduce taxable income of the income beneficiary and reduce thedistribution deduction to the trust if the trust is required to distribute all incometo the beneficiary. 125 Neither the courts nor the Service have explored all thedetailed tax ramifications of equitable adjustments and, therefore, the overalleffect of an adjustment pursuant to a section 643(e)(3) election is speculative.

VI. CONCLUSION

In certain situations a fiduciary's section 643(e)(3) election to recognize cap-ital gain or loss upon in kind distributions from a trust or estate may lead toinequitable consequences to beneficiaries. This results from the interaction ofthe DNI scheme and local law. In such circumstances the policy first establishedin Warms argues for an equitable adjustment, provided no provision in thetrust instrument or will directs otherwise. The Warms adjustment, although notuniformly applied, has often been adopted where inequitable consequences resultfrom a fiduciary's election. It is applied less frequently when the election ordiscretion has not been exercised.

The section 643(e)(3) election most often arises when the fiduciary, pursuantto his duty to minimize taxes, seeks to lower overall tax liability of the trustor estate and the beneficiaries. However, as illustrated, one beneficiary mayhave an increase in tax liability while another beneficiary's tax liability is re-duced. Thus, the exercise of the fiduciary's duty to minimize taxes conflicts

121. Id. 5 1239(b)(2).122. See id. S 1239(b) (not included in the definition of "related persons").123. Id. S 267(a)-(b)(6).124. See Blattmachr, supra note 10, at 1400.125. Id. at 1404.1, 1410. However, by reducing the amount of accounting income, DNI

that would otherwise be taxed to the beneficiary is not taxed to the corpus of the trust, whichmay warrant a further adjustment. Id.

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1986] EQUITABLE ADJUSTMENT DOCTRINE 831

with his duty of impartiality. An equitable adjustment among the beneficiariesis often necessary to enable the fiduciary to satisfy both duties.

Draftsmen should ensure that fiduciaries are given the flexibility and nec-essary powers to make appropriate elections, including the new section 643(e)(3)election. Furthermore, it would be appropriate for the trust or will instrumentto specify that no tax election will create the need for equitable adjustmentsamong beneficiaries whose interests might be affected. In other cases it mightbe appropriate for the governing instrument to specifically require equitableadjustment in the event of a section 643(e)(3) election. Only through an un-derstanding of the new section 643(e)(3) election and the principles of the equitableadjustment doctrine can the proper decision be made.

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